A Lesson in Patience and Discipline

Most retail traders and investors have heard at some point that discipline is important and that emotion should be taken out of trading decisions, but what does that really mean? The story of my position in the Vanguard FTSE Emerging Markets ETF (VWO) is a good example of both.

At the beginning of this year, I wrote a piece laying out my favorite plays for 2014. Front and center was the opinion that emerging markets, taken as a whole, would have a good year and that VWO represented a convenient, broad-based play on that belief.

In the month that followed, anyone who followed my advice had their patience and discipline tested and no doubt thought I was an idiot, as VWO lost more than 8%, pretty much going down in a straight line.

If you had read the entire article, however, you would be aware that while this was disappointing, it was hardly unforeseen, nor was it disastrous. The whole point was that long-range predictions are hard, and that if you are going to attempt to make them (and back them up with cold, hard cash), you had better be aware that things could go wrong.

To that end, an important part of the call was a recommendation to place a stop-loss order to guard against a drop below $36 and limit potential losses to around 10%. The low on that big fall was $36.65, so that stop should not have been triggered. This highlights the importance of setting exit levels for trades, even long-term ones, at the time of entry rather than on an ad-hoc basis. If looked at rationally at the time of buying, the low of the summer 2013 drop at $36.01 was likely to hold. If you didn't think about an exit point in advance, however, it would have been easy to get squeezed out of your position as VWO fell out of bed. By being disciplined at the time of placing the trade, you avoided the classic "sell at the bottom" mistake.

When you set a stop loss at the correct level and watch a stock bounce off it, it results in a nice warm and fuzzy feeling, but it doesn't mean that the tough decisions are over. After months of staring at a loss, you are finally looking at a profit, and it is time to review the position.

Let's start with a basic truism that anybody who has ever worked in a dealing room has had drummed into them: You are never wrong to take a profit. The high on Jan. 3, when the original article was published, was $39.93, so, assuming you hit that, you are looking at a chance to take around a 4% profit by selling VWO at around $41.60, heave a big sigh of relief and move on.

In some ways, for the good of your future mental health, that would probably feel like the right thing to do in this situation. Imagine how you would feel if it falls again and this time does trigger the stop. However, given that we are all aware that emotions are a bad basis on which to trade and that the future is uncertain, acting on the basis of possible future emotions makes no sense. It is far better to stop and rationally think again.

I would argue that the base case for investing in VWO is intact. There is an enormous amount of global liquidity and cash chasing a return. After a stellar 2013 in the stock markets of developed countries, value is hard to find, and emerging-market stocks are still lagging behind. With the $36 support level now even stronger, a return to around $50 and a 25% profit on your initial investment now looks more likely than a break lower and a 10% loss, especially given the news that China is showing signs of a return to more robust growth. If you were just starting out, then a risk/reward ratio in your favor with more chance to win than lose would be a no-brainer, so why sell now? The only reason to sell would be to protect your emotions.

I am not delusional, so I doubt that anybody was waiting with bated breath for my picks on Real Money, slavishly followed them and is now waiting to be told what to do next. This isn't advice for that mythical being. Rather, it is an observation that, with a disciplined and logical approach, investors can avoid costly mistakes. When you enter a trade with an idea and a plan, stick to it. When a re-think is called for, consider likely outcomes, not how you will feel if one of those outcomes occurs.

Following these simple rules won't stop you from placing losing trades. Nothing will, and understanding that basic fact is essential to success overall. The more you act in a disciplined way and take emotional considerations out of your trading decisions, though, the more likely that overall success becomes.

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